Market Breadth and VIX based indicators
There are two types of indicators:
- delayed indicators - they appear at the beginning of new trend; trend direction is already shaping up, but is still not evident to majority of investors
- early indicators - they appear before new trend starts to shape up and may take some time to become evident. These are based on various breadth indicators.
Longterm model is defined on weekly chart and include several indicators:
- current value of SPX and its rate of change delayed indicator
- ration between 1-month volatility VIX and 3-months volatility VXV (VIX3M) - fear indicator delayed indicator
- indicators of market sentiment
- equity put/call ratio - early indicator
- breadth indicators - early indicator
- new highs and new lows on NYSE
- Advance/decline ratio
- ratio between buy and sell volume on NYSE and NASDAQ
- oscillators (Williams %R, stochastic) – delayed indicator
- Relative strength indicator RSI - delayed indicator
“There is nothing wrong with staying in cash for longer periods of time.”
Why make decisions on which stocks to buy and sell on a weekly basis? This is how I avoid making quick, impulsive decisions on days when everything seems as if the whole world is coming to an end, therefore, I immediately need to sell everything I’ve got and then buy as much as possible a few days later. It is often the case that stock markets pick themselves up in the course of a week. Sometimes I also make decisions during the week, whereby I use my midterm model (read more about it here).
In short, when the main model tells me to exit the market or enter it, I adhere to it 100 %.
Based on these indicators, I have created my own model that enables the investor to withdraw from the market in a timely manner – i.e. when the market is starting to overheat or prior to large falls in the market. pravočasen vstop na trg po večjih korekcijahAt the same time, the model enables the investor to enter the market in good time following major corrections, making it possible for the investor to take advantage of a large part of the growth of a new bullish trend.
The chart below illustrates all major model indicatorsthat signal when it is time to enter the market and when to exit it.Green triangles indicate periods in which it is wise to invest in stocks. Where there are no such signs, it is better to step back and invest in money or bond funds.
With the application of my model, the investor would to a great extent avoid all three bearish trends, while at the same time, they would benefit from an almost 100-percent index growth in the period between 2003 and 2007, while during 2009 – 2020, this growth was as high as 270%.
The chart below illustrates all three major bearish trends from 2000 to 2020 that the investor could have avoided and then entered the market in good time when conditions would be more favourable.
How to use the model to exit equity funds in due time?
In the period between 2009 and 2020, you would have exited equity funds seven times. In all cases, the indicator was triggered at the start of the correction or bearish trend. You would have suffered minor losses (5 – 12 %), but at the same time, would have avoided the major part of the correction.
During the correction that began at the end of 2018, the S&P 500 index lost 20 %; the investor using my model would have lost a mere 6 %.
“Market always fools the majority; don’t be one of them.”
The fastest bearish trends in history that began in 2020 due to uncertainty following the lockdown of economies surprised most investors because they had felt safe (market fools the majority). They started selling everything they had – from stocks to bonds, and even gold did not appear to be a safe investment. The safest thing to do was to exit the market in due time. The S&P 500 index lost 35 % of its value, the investor using my model would have lost a mere 13%. Simultaneously, the first warning signs appeared, signaling to investors that it would be wise to reduce their exposure in stocks.
“Market always finds a way of humbling you. When you get too greedy it is probably a time too sell.”
The rapid fall was followed by an intense rebound that fully made up for the losses and more, because central banks flooded the markets with cheap money, while the effect of the epidemic on economies was less severe than first anticipated. We all know that today. But then, in March 2020, it was not that simple because there was a great fear and volatility was extremely high. The world was at the brink of a great recession. I firmly believe that you would have slept better had you not been exposed to stock markets.
OK, I can use the indicators to exit the stock markets. What about re-entry? When is the right moment? Does the model offer this possibility as well?
The answer is YES. The model signals to us when it would be wise to re-enter stock markets. The chart below illustrates rare cases of such signals from 2009 to 2020. The more such signals appear in a short period of time, the more forceful the bullish trend that follows will be.
The last such example was in May 2020 when the fastest bearish trend in the history of stock markets ended. Since then and until February 2021, the S&P 500 index gained about 35 % of its value.
There were also other signals based on the sentiment of investors, indicating that the time to re-enter the stock markets is approaching. The first signals appeared in the 6th week and on March 16, while the final, key confirmation came in May 2020 (chart above).
It is often the case that investors exit their investments at the exact moment the big institutional investors start re-entering the market. This is when small investors suffer major losses, are emotionally devastated and scared, and that is why they are afraid to re-enter the market. Therefore, they often re-enter the market when it’s too late and when “big” investors are beginning to withdraw. And the cycle is repeated. This is how it has always been and will continue to be in financial markets.
The “unpredictable” movements of financial markets are thus a result of the investors’ greed for high earnings on one hand and fear of great losses on the other. Bearish and bullish trends are a result of actions of the so-called invisible hand of the market or, in other words, the psychology of investors.
With the application of the right methods, models and approaches, the “unpredictable” movements can be predicted (yes, I’m aware of the paradox), whereby we do not rely on our emotions, fears and feelings that lead us to wrong decisions.
“When the time comes to buy, you won’t want to.”
Walter Deemer, Wall Street legend
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